A call or a call option is a type of derivative contract that gives you (the holder) the right to buy an asset at a stipulated price at or before a specified date. If this price is less than the cost of purchasing the asset in the open market, you can make profits through the difference as an owner of the call option. Options trading can be lucrative; however, at the same time, it is more complex when compared to regular stock trading activities.
In this article, we will discuss the advantages of acquiring options that are in the money (ITM).
Additional read: Money market
A game for professionals - More about ‘in the money’ call options
When the underlying asset’s existing market price exceeds the strike price of the call option, then a call option is in the money (ITM). The call option is considered to be in the money because the call option purchaser is entitled to purchase the stock beneath its current trading price. When an option grants a purchaser the right to purchase an underlying asset below the current market price, that right possesses something known as an intrinsic value. A call option’s intrinsic value is equivalent to the difference between the underlying asset’s current trading price and the strike price.
A call option presents the holder or the buyer with the right but does oblige them to buy the underlying asset at a pre-decided strike price on or prior to the date of expiry.
What does it mean if a call option is out-of-the-money?
Essentially, ‘in the money’ is attributed to an option’s ‘moneyness’. Moneyness stands for the correlation between a derivative’s strike price and the price of the underlying asset. A call option is deemed ‘out of the money’ when the strike price surpasses the underlying asset’s price.
In general, the more ‘in the money’ an option is, the more expensive it will be to purchase. On the other hand, ‘out of the money’ options are comparatively cheaper and cost even less the further they are from being ‘in the money’. However, it is imperative to note that several factors impact the price of an option, such as expiration and volatility.
Additional read: Call and put options
What is an example of a call option in-the-money?
Assume a day trader purchases a single call option of ‘XYZ’ company with a strike price of Rs. 100 with a date of expiry after a month. If XYZ’s stock trades above R. 100, the call option is in the money. Let’s say XYZ’s stock is trading at Rs. 110 the day before the call option is scheduled to expire. Then the call option will be in the money by Rs. 10 (Rs. 110 - Rs. 100). In this case, the trader can exercise the call option and buy 100 shares of XYZ company for Rs. 100 apiece and sell the shares at Rs. 110 apiece in the open market. Basically, they will make a profit of Rs. 1000, [100 x (Rs. 110 - Rs. 100)].
What are the advantages of in-the-money call options?
- When a call option goes in-the-money, the option’s value rises for investors. On the other hand, because they only have extrinsic value, out-of-the-money (OTM) call options are considered to be significantly risky.
- When a call option goes in-the-money, you can exercise the option to purchase an asset for less than what it costs in the open market. This makes it possible for you to generate gains off the option irrespective of the conditions operating in the current options market.
- Certain parts of the options market could be illiquid occasionally. Calls that are out-of-the-money or calls on thinly-traded assets can be tricky to sell at the prices predicted by the Black-Scholes-Merton (BSM) model. Therefore, it is advantageous to have a call option to go in-the-money. To be precise, at-the-money (ATM) options are typically the most liquid and frequently traded because they encapsulate the conversion of out-of-the-money options into in-the-money options.
- Options are uncommonly exercised prior to the date of expiry, as doing so wipes out their residual extrinsic value. The primary exception to this is very deep in-the-money options, where the extrinsic value accounts for a small part of the entire value. Exercising call options, therefore, becomes more viable as the expiration date comes closer and time decay amplifies rapidly.
Additional read: Shares
Is it better to buy call options in-the-money?
In-the-money options are highly likely to make gains, but out-of-the-money options are much more economical to purchase. This makes out-of-the-money options an appealing instrument for traders who wants their underlying asset to make lucrative profits. The more out-of-the-money an option, the less expensive it is on the pockets.
Thus, investors with a bullish outlook and higher risk appetite prefer out-of-the-money call options. While they have the potential to provide higher returns, they are also extremely risky. For this reason, investors with a lower risk appetite and wish to reduce their potential losses opt for in-the-money call options.
Additional read: Covered call
Closing thoughts
A call option is a derivative contract that entitles the holder to purchase an asset at a specified price on or before a predetermined date. Once a call option is in-the-money, you have the option to exercise it and purchase an asset for a price lower than its market value. While they are safer, they are also more expensive than OTM options. However, OTM options are riskier. So ultimately, it is up to you what you want to choose. In any case, it is recommended you meticulously weigh the pros and cons of each to make an informed decision.
